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Thursday, March 31, 2011

Mark Thoma has an interesting article on the dilemma facing the Fed: does it respond to rising inflation or the anemic economic recovery? On the one hand, the Fed is concerned about maintaining its inflation fighting credibility and its independence from Congress. Thus, it wants to be seen as vigilant on the inflation front. On the other hand, it does not want to undermine the economic recovery, as sluggish as it is. What will it do? For a number of reasons, Thoma believes the Fed will err on the side of fighting inflation. This is unfortunate because any honest, fact-based assessment of the economy will show that long-term inflation expectations are well anchored, money demand remains elevated, and there remains much economic slack.

Now no one wants to see the the return of 1970s-type inflation. But what would be appropriate currently is some catch-up growth in nominal spending (and by implication inflation) to bring nominal income back to trend. Prior to the recession, households and business made many economic decisions based on an expectation of that nominal income would continue growing at about the same it had over the past few decades. As is well known, the growth in nominal income collapsed in late 2008, early 2009 and has never recovered. Consequently, those past decisions are now hindering a robust recovery.

What is needed then is a monetary policy rule that is systematic and predictable, but at the same time flexible enough to allow nominal spending to return to its trend when it falls off . There is a name for this: NGDPleveltargeting. Note that this approach, if widely understood, would make it easy for the Fed to have some higher inflation during the catch-up stage while keeping long-run inflation expectations anchored. Not only that, such a rule would also anchor nominal spending expectations and thus make it unlikely that there would be a collapse in nominal spending in the first place. This is such a no-brainer! If Congress really wants to reform the Fed this is how it should be done.

P.S. A price level target would also allow for some catchup inflation, but because of how it would handle supply shocks it is better to go with a NGDP level target.

Wednesday, March 30, 2011

It’s clear which way the Fed has erred recently. It has done too little. It stopped trying to bring down long-term interest rates early last year under the wishful assumption that a recovery had taken hold, only to be forced to reverse course by the end of year.

Given this recent history, you might think Fed officials would now be doing everything possible to ensure a solid recovery. But they’re not. Once again, many of them are worried that the Fed is doing too much. And once again, the odds are rising that it’s doing too little.

Yes, the Fed fell asleep on the job last year and yes, QE2 was a weak version of what could have been a more effective monetary stimulus program where the price level or nominal GDP level was targeted. What is not true is that a successful monetary stimulus program will be defined by sustained low long-term interest rates. A successful monetary stimulus by definition would lead to a robust recovery. Though this would be initially associated with lower interest rates, the robust recovery should ultimately lead to higher interest rates. Given the forward looking nature of markets, just the expectation of an increase in economic activity should put upward pressure on current interest rates. Initially, this seemed to be happening with QE2: long-term interest rates dropped and then started to increase as growth expectations picked up. Bernanke, of course, took credit for this development. Now, long-term rates are nudging down again as growth expectations stall. One could call this a passive tightening of monetary policy.

Update: I meant to include this picture of the the nominal and real (i.e. TIPS) 10-year treasury interest rates.

It is hard to believe that it has been two years since hyperinflation ended in Zimbabwe. In fact, enough time has passed that now the 100 trillion dollar Zimbabwe note shown below is gaining value with collectors.

The reasons the Zimbabwe hyperinflation ended were (1) the country abandoned the production of its own currency and (2) it allowed foreign currencies to be used as legal tender. As result, foreign currencies started functioning as the medium of exchange and goods started appearing in formerly barren stores throughout Zimbabwe. The main foreign currency that is now used in Zimbabwe is the U.S. dollar.

Now dollarization means your monetary policy is tied to the U.S. monetary policy, so it would be interesting to know how QE2 is affecting Zimbabwe. Also, to earn more dollars Zimbabwe needs to run trade surpluses, but Robert Mugabe's economic policies are not very conducive to that end. Thus, while dollarization is tied to the ending of hyperinflation, it could also impose a straitjacket on the economy. One solution would be to allow a free banking system in Zimbabwe, where the U.S. dollar remains the reserve currency but banks are allowed to issue their own notes and coins that would be backed by the dollar. If set up correctly, this free banking system could solve most of the money issues. (See this Federal Reserve Bank of Richmond interview with George Selgin for more on how free banking would work.)

One issue that has emerged is the shortage of coins. Here is a central banking.com article on the issue (hat tip: Steve Hanke):

Local media reported last month that the Federal Reserve had formally agreed to supply US coins to Zimbabwe, where shopkeepers are suffering a shortage of change. The African economy switched to dollarisation in early 2009 in order to temper a severe bout of hyperinflation.

However, the Fed has not made a formal agreement to supply Zimbabwe with coins. Instead, US government officials are understood to have suggested to the Zimbabweans that if they want coins, they get them through a commercial bank that specialises in wholesale shipment of currency.

The IMF is said to have suggested that Zimbabwe have its own coins but back them with foreign assets.

Zimbabwe agreed to allow businesses to accept multiple currencies, including the dollar, the rand, the pula, the euro and sterling, in January 2009. Dollarisation occurred the following month after the election of Morgan Tsvangirai.

Obviously, there are bigger structural problems to address in Zimbabwe but at least the country has made significant progress reforming its monetary system.

Tuesday, March 29, 2011

Since Paul Krugman is talking about the 150th anniversary of the U.S. Civil War outbreak, it is worth recalling the great monetary experiments created by the Civil War. This great event resulted in the establishment of three monetary regions in the United States: the Greenback monetary system, the Yellowback monetary system, and the Confederate monetary system.

The Greenback monetary system emerged in the East when the gold standard was suspended so fiat currency could be introduced in 1862. There was no central bank at the time, so the new fiat money popularly known as the greenback was introduced by the U.S. Treasury. Ironically, the Treasury Secretary who introduced the Greenbacks, Salmon Chase, would later become Chief Justice of the Supreme Court and rule that the fiat currency was unconstitutional. The Greenbacks were highly inflationary as seen in the figure below:

Between 1862 and 1865, the price level rose about 60% because of excessive issuance of greenbacks. Over the next thirty years, the price level decline by almost 50% due in part to a desire to return to the gold standard by 1879. Doing so required either retiring the greenbacks (done initially) or freezing the stock of greenbacks (done later) and allowing the economy to grow into them. Once the gold standard was resumed, the price level continued to fall as the growth in gold was slower than the growth of the economy. Eventually, the price level was about where it was prior to the Civil War. Fortunately, this 30 year run of falling prices was associated with on average rapid real growth, rising real wages, and increasing financial intermediation as noted here.

The Yellowback monetary system emerged in California during the Civil War. California never left the gold standard and it dollars remained gold-backed. These so called yellowbacks floated against the greenbacks until resumption of the gold standard in 1879. Greenbacks did find their way to California, but were quickly returned to the East as payment. No greenback banks every took hold in California. Because the Yellowback monetary system continued until 1879, the United States truly was a dual currency nation during this time. Hugh Rockoff marvels at this dual monetary experiment:

[F]rom 1865 to 1879, when the greenback currency became convertible into gold we have a monetary rarity: a strong political union, untouched by war, with two currencies, greenbacks and yellowbacks, circulating at a floating exchange rate.

The Confederate monetary system emerged in the South as a way for the South to gain autonomy and finance the war effort. The confederate dollar was a fiat money like the greenback and its value ultimately rested on the outcome of the war. Thus, whenever the South was winning victories the confederate dollar appreciated and when the North was winning it depreciated. Here is a picture from Feenstra and Taylor International Economics textbook that captures these developments:

Though there were other important monetary changes during Civil War like the introduction of the flawed National Banking System, the three monetary system that emerged during the Civil War was truly a remarkable development.

Ryan Avent is right that we should not get worked up over the possibility that U.S. core inflation appears to have bottomed out. A potential turn around in core inflation does not negate that fact that the demand for money remainselevated and is hampering a robust recovery in nominal spending. In addition, forward-looking measures of inflation indicate that long-term inflation expectations remain below the Fed's implicit 2% inflation target as seen in the figure below:

Between the elevated demand for money and below-target inflation expectations, it is hard to see why one should get excited about the recent activity in core inflation. These developments, if anything, indicate that monetary policy may still be too tight.

Monday, March 21, 2011

Nick Rowe recently made the case that excess money demand is the fundamental reasons behind the Keynesian and Monetarist theories of recession. Alex Tabarrok responds that if Nick is correct there should be a rise in barter transactions and the use of alternative currencies. He shows that there was extensive use of both during the Great Depression. Tabarrok has a harder time finding evidence of these occurring during the recent recession. Some commentators provide anecdotal evidence that barter trade has risen. Whether it has or hasn't, the bigger point is that barter and the use of alternative money assets is a way to mitigate the impact of money demand shocks. Even if the data were to show these mitigaters are not being used, such a finding could simply mean that the recovery will be prolonged rather than being evidence against Nick's hypothesis. After all, there is compelling evidence of a serious excess money demand problem in the U.S. economy.

Friday, March 18, 2011

I recently made the case that money demand remains elevated and continues to be a drag on the economy. The flow of funds data for 2010:Q4 supports this conclusion. This data shows that the share of nonfinancial private sector assets in liquid form remains relatively high. Households and firms continue to hold significantly more liquid assets than they did prior to the recession. The good news is that it the share of liquid assets dropped slightly in Q4. Presumably, the share of liquid assets continued to decline in early 2011 though recent global events may change that.

Using the Flow of Funds data, the figure below shows for the combined balance sheets of households, non-profits, corporations, and non-corporate businesses the percent of total asset that are highly liquid ones (i.e. cash, checking accounts, saving and time deposits, and money market funds) as of 2010:Q4. The figure also shows M3 velocity.

Other than the 1995-1999 period, there appears to be a strong negative relationship between these two series. The reason is obvious: the greater the demand for liquid assets the greater the fall in spending and money velocity. If we take the year-on-year growth rate of these two series, exclude the 1995:Q1-1999:Q4 period, and throw them into a scatterplot we see this indeed is a strong relationship*:

This liquid share seems to provide a good indicator of whether there remains an excess money demand problem that is preventing a robust recovery. This, then, is the metric you should be watching but aren't. Until it falls further we can expect nominal spending to remain sluggish.

Monday, March 14, 2011

Bennett McCallum is one of the most accomplished monetary economists of the past few decades. He also happens to be a champion of nominal GDP targeting. In a paper he did late last year for the Shadow Open Market Committee he discusses some of the problems with inflation targeting. He notes that even if one takes inflation targeting to be of the Taylor Rule type--where there is both an inflation and output gap term--there are still problems with it:

I would myself argue that the most prominent form of a typical IT policy rule, as described above, has a weakness stemming from its inclusion of the output gap as a second target/indicator variable to respond to. In particular, measurement of the “gap” requires measurement of the “natural rate” of output; but the latter is an unobservable and unmeasured variable that is conceptually different for every different specification of price-adjustment behavior used in the adopted macro model. And the price-adjustment relationship is arguably the single weakest and most-disputed portion of any macro-econometric model! For this reason, among others, I have long believed that use of the change in aggregate nominal spending—i.e., the change in a refined version of nominal GDP—would represent a more sensible combination of inflation and real-variable measures than is provided by the two variables of the traditional IT rule.

It is good to see McCallum reaffirm his support of nominal GDP targeting. As readers of this blog know, I too am a bigfanof nominal GDP targeting. It would be interesting to learn what McCallum thinks about nominal GDP level targeting and Scott Sumner's proposal for nominal GDP futures targeting.

Sunday, March 13, 2011

Look at the figure below. It shows the monetary base for the Eurozone and the data comes directly from the ECB. The monetary base follows a striking trend that begins in 2002 and continues to the present. Even the financial and Eurozone crises create only temporary deviations from this trend. This trend is so straight it creates the appearance that the ECB is actually targeting the monetary base rather than following its two pillar strategy.

This upward trend not only creates the appearance of a monetary base target, but it also turns out to be very important to the trend growth of nominal GDP in the Eurozone. To see this, note that the monetary base, B, times the money multiplier, m, equals the money supply, M (i.e. Bm = M). In turn, the money supply times velocity, V, equals nominal spending or nominal GDP, PY (i.e. MV=PY). Putting this all together, we get the following identity:

BmV = PY.

Now let's unpack the first two components of this identity, Bm, that make up the money supply. Using the M3 money supply to solve for the money multiplier, (i.e. m = M/B), the following figure shows what has been the main determinant of growth in the money supply:

Other than a brief run up in late 2001-early 2002, the money multiplier had been relatively flat prior to the financial crisis. Thus, most of the M3 money supply growth has come from increases associated with the trend growth in the monetary base. After the financial crisis, the monetary base seems to adjust to the shifts in the money multiplier as an offset.

The figure below shows M3 along with velocity, the third component of the above identity. Here we see a sustained rise in M3 being offset by a sustained fall in velocity up till the financial crisis. This drop in velocity seems strange given that it occurs during the housing boom.

This and the previous figure reveal that the remarkable post-2002 trend in the monetary base was needed to offset the effects of a flat money multiplier and falling velocity on nominal GDP in the Eurozone. The figure below reveals how important the monetary base growth was to nominal GDP growth during this time. The figure shows actual nominal GDP and a counterfactual version, where the monetary base is grown at its 1999-2001 average monthly growth rate from 2002 on rather than at its actual growth rate. This alternative monetary base series is then multiplied times the actual money multiplier and velocity (i.e. BmV) to get the counterfactual nominal GDP. Here are the results:

So it seems the ECB was increasing the monetary base fast enough to keep nominal GDP growing at a stable pace. While that can explain the upward trend in the monetary base, it does not explain (1) why the trend was so straight, (3) why the money multiplier was relatively flat, and (3) why velocity was falling. Could it be the ECB was secretly targeting the monetary base via some kind of Bennet McCallum-type nominal GDP rule?

Friday, March 11, 2011

Below is a figure of the Euro monetary base. I find it puzzling for two reasons. First, it shows an upward trend that starts in 2002 and continues to the present. The monetary base has more than doubled since this trend begins. What explains it? It almost looks like a long, drawn out quantitative easing program. The second thing to note is even the financial and Eurozone crisis is not enough to deter the ECB permanently from this trend. The commitment to the trend seems to be driving the sharp fall in the monetary base from June 2010 to the present. So what is going on here?

Caroline Baum goes after the confused thinking on oil prices and inflation:

It must be the noxious fumes or the stratospheric prices because crude oil crossing the $100 threshold makes normally thoughtful individuals funny in the head.

The early symptoms of high oil price syndrome, or HOPS, can easily be masked or confused with a more generalized form of lazy economic thinking.

For example, those afflicted with HOPS start making assertions that higher oil prices are inflationary, as if relative price changes can morph into an economy-wide rise in prices without help from the central bank.

One implication of this is that the Fed should not tighten monetary policy since the higher oil prices are just a relative price change. The Fed should also not loosen monetary policy to ease the pain of such relative price shocks. As Baum notes, that is what the Fed did in the 1970s and look what it got us. The Fed should only respond to aggregate demand shocks. This piece dovetails nicely with Mark Thoma's post where he considers whether the Fed should respond to commodity prices in general.

Update: I should have been more clear: a relative price shock can lead to a higher price level, but not higher trend inflation. There might be a one-time increase in the inflation rate, but not a permanent one from such shocks. The post title has been adjusted accordingly.

Thursday, March 10, 2011

That is what Filipa Sá, Pascal Towbin, and Tomasz Wieladek find in their new paper. Moreover, they find that the effects of monetary policy and the saving glut were more pronounced in those economies with more developed and securitized mortgage markets. On this latter point, Roger Ahrend similarly finds that easy monetary policy had its biggest effect on housing in periods of financial deregulation and innovation. The Sá et al. paper also is consistent with the findings of Thierry Bracke and Michael Fidora who show that monetary policy shocks and global saving glut shocks contributed to the buildup of global economic imbalances. These nuanced studies that take a global perspective and find both monetary policy and global savings to have mattered are far more satisfying than the "Not us!" research being pushed by former and current Fed officials lately.

It would be nice, however, if these nuanced studies did more to tease out (1) how much of the saving glut was due to truly exogenous developments in the emerging economies versus (2) how much was due to endogenous responses by these economies to the Fed's loose monetary policy. In other words, how much of the saving glut was simply recycled U.S. monetary policy?

Wednesday, March 9, 2011

Why has total current dollar spending been so anemic? Even after accounting for the run up in nominal spending during the housing boom, it is still below trend and continues to be a drag on the recovery. A useful way to answer this question is to look at the three components of nominal spending: the monetary base, the money multiplier, and velocity

The monetary base is simply the stock of money assets directly created by the Fed. The money multiplier shows to what extent the monetary base is supporting expansion of other more commonly used money assets like checking, saving, and money market accounts. If the monetary base is not supporting an expansion of these other money assets it is because there is an elevated demand for the monetary base and vice versa. The money multiplier, therefore, is an indicator of the demand for the monetary base. Velocity shows how often the more commonly used money assets like checking, saving, and money accounts are used in transactions. The lower the velocity the less these money assets are being used for spending and vice versa. Velocity, then, is an indicator of the demand for these broader measures of money assets which we call the money supply.

By definition the product of these components makes up total current dollar spending or nominal GDP:

BmV = PY,

where B is the monetary base, m is the money multiplier, V is velocity, P = price level, Y = real GDP, and PY= nominal GDP. (Note that this identity is just an expanded version of the equation of exchange. where the money supply , M , is M = Bm.) Using the MZM money supply measure and monthly nominal GDP from Macroeconomic Advisers to construct velocity and the money multiplier, the left-hand side of the above identity is plotted below:

This figure indicates that declines in the money multiplier and velocity have both been weighing down nominal GDP ever since the collapse in late 2008. Excess demand for the monetary base and the money supply thus continues to be a problem. The sustained decline in the money multiplier presumably reflects the ongoing reluctance of banks to lend given the relative safety of parking excess reserves at the Fed and earning 0.25%. The sustained decline in the velocity indicates that the rise in real money demand has yet to return to pre-recession levels. This figure also shows that the Federal Reserve dramatically increased the monetary base, which should, all else equal, have put upward pressure on nominal spending. However, all else is not equal as the movements in the money multiplier and the monetary base mostly offset each other. This offset is no coincidence, as most of the monetary base increase was the result of the Fed's attempt to save the financial system under QE1. The figure indicates the problem with QE1 is that it was so focused on saving the financial system it ignored the fall in velocity. QE2 is an imperfect attempt to address this oversight by the Fed.

So the reason for the ongoing weakness in nominal spending is that money demand remains elevated and continues to be a drag.

Tuesday, March 8, 2011

(1) Local communities such as this one in Spain resort to using old currency to stabilize spending.

(2) Ambrose Evans-Pritchard calls the ECB a flat-earth central bank for its handling of supply shocks and its attempt to kick Spain in the teeth.

(3) The ECB President says interest rates will be increased soon even though the core inflation rate declined in January and inflation expectations remain stable.

(4) An ECB Governing Council member says interest rates will rise as many as three times this year even though Eurozone nominal spending remains far below trend.

(5) Two ECB Governing Council officials say the ECB will actually tighten sooner than what is implied in (3) even though more credit downgrades are likely and credit spreads are increasing for the Eurozone periphery.

Friday, March 4, 2011

Lately, that seems to be the message coming from current and past Fed officials regarding the housing and credit boom in the early-to-mid 2000s. First Ben Bernanke, then Vincent Reinhart, and now Janet Yellen have come out saying it was excess savings by foreigners and failings in the U.S. private sector that was the root cause of the boom. No blame is assigned to the Fed. They ask how could the Fed have created a liquidity glut that drove down world interest rates and sparked off a global housing boom?

The answer is easy: the Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s. Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). As I showed in a recent post, there is strong evidence that a good portion of the foreign reserve buildup in the global economy during the 2000s can be tied to U.S. monetary policy.

What is amazing is that on one hand these Fed officials will acknowledge the Fed's global monetary power and then completely ignore the implications of this for early-to-mid 2000s. I wish they wrestle with the four questions I presented to Ben Bernanke after his recent speech. In case any of these Fed officials are interested, I am about to wrap up a coauthored paper that more fully develops the implications of the Fed's monetary superpower status during the housing boom. I would be glad to share it with them.

Update: Here is a paper from the ECB that empirically estimates how important the global saving glut was versus monetary policy. This is the abstract:

Since the late-1990s, the global economy is characterised by historically low risk premia and an unprecedented widening of external imbalances. This paper explores to what extent these two global trends can be understood as a reaction to three structural shocks in different regions of the global economy: (i) monetary shocks (“excess liquidity” hypothesis), (ii) preference shocks (“savings glut” hypothesis), and (iii) investment shocks (“investment drought” hypothesis). In order to uniquely identify these shocks in an integrated framework, we estimate structural VARs for the two main regions with widening imbalances, the United States and emerging Asia, using sign restrictions that are compatible with standard New Keynesian and Real Business Cycle models. Our results show that monetary shocks potentially explain the largest part of the variation in imbalances and financial market prices. We find that savings shocks and investment shocks explain less of the variation. Hence, a “liquidity glut” may have been a more important driver of real and financial imbalances in the US and emerging Asia than a “savings glut”.

The Texas legislature seems likely to pass a law allowing people to carry concealed weapons on campus. Having observed enough shootings of professors by students in the U.S. over the past 45 years, I think this is a dreadful idea. But it has interesting implications for wages. Some people who might be willing to take jobs at Texas campuses will be hesitant to do so. Unless there are enough others who welcome guns on campus, which I doubt, Texas universities will have to pay professors more — have to pay a compensating differential for the risk of being shot — or will be hiring lower-quality faculty members than before. Interestingly, although there are many more undergrad than grad students, it seems like the large majority of shootings of professors have been by grad students. Assuming that’s true, the new law will cause a change in wage differences between those who teach mostly undergrads and those who teach most grads, since teaching grads will become relatively riskier. I doubt that our legislators thought about the extra labor costs, or the diminution of quality, that their ideas are likely to create.

Time to start wearing a Kevlar vest to class. At least I will get a pay raise to pay for it.

Inflation targeting just got a black eye in the United Kingdom. Now its about to get another one as the European Central Bank (ECB) President Jean-Claude Trichet signaled interest rates will probably be increased in April. As was the case in the United Kingdom, the motivation for this move is concerns about maintaining the central bank's inflation target. And like the United Kingdom too, the inflation concerns are not warranted given that core inflation is low and inflation expectations remained well anchored according to the ECB.* Morever, aggregate spending is still well below any reasonable trend. For example, the figure below shows Eurozone nominal GDP is below its 1995-2004 trend. (This time period is chosen to show that nominal GDP is still below trend even after accounting for the housing boom run-up in spending.)

As Kantoos notes, all of these facts mean that tightening monetary policy in April makes no sense. Especially if the ECB wants to prevent a crackup of the Eurozone. The Eurozone is not an optimal currency area and inflation targeting is about to make that even more apparent. This will definitely be another black eye for inflation targeting.

*The ECB reports in its February, 2011 Bulletin the following on page 54: "Inflation expectations over the medium to longer term continue to be firmly anchored in line with the Governing Council’s aim of keeping inflation rates below, but close to, 2% over the medium term."

Thursday, March 3, 2011

This may surprise you, but Christina Romer and John Taylor both agree on an important issue. They both see the need for an explicit monetary policy rule that would provide more transparency and predictability of the Fed's actions. Here is Christina Romer in a recent article:

[The Fed] could set a price-level target, which, unlike an inflation target, calls for Fed policy to take past years’ price changes into account. That would lead the Fed to counteract some of the extremely low inflation during the recession with a more expansionary policy and lower real rates for a while. All of these alternatives would be helpful and would retain the Fed’s credibility as a defender of price stability.

So Romer wants a price level rule that would keep the price level growing according to some target rate. This would not only commit the Fed to long-term price stability, but it would also create more certainty for the markets. John Taylor makes the same point in his critique of Bernanke's recent testimony before congress:

[T]he exchange between Chairman Bernanke and Senator Toomey suggests that the Fed is unclear about what monetary policy strategy it is using for the interest rate. Is it the Taylor Rule, as in the first response? Is it the rule incorrectly attributed to me in 1999, as in the second response? Is it some estimated rule, as in the third response? Or is it something else? It would be useful to know what the strategy is. Greater transparency about the strategy would add greatly to predictability and would help markets understand whether quantitative easing will be extended or when the interest rate will break out of the 0-.25 percent range.

I agree with both of them. We desperately need a rule-based approach to monetary policy that would provide more certainty. Instead of a price level rule or a Taylor rule, though, let me suggest another alternative: a nominalGDPlevel target. If congress is serious about narrowing the mandate of the Fed, they should could consider this option too.

In the current setting, it appears that economic activity is expanding and inflation is higher than it had been. One may choose to interpret this as resulting from the Fed's quantitative easing. However, I am not signing onto that one. I recall reading recently that QE 2 was basically canceled out by offsetting changes in Treasury funding operations. That is, as the Fed bought more long-term bonds, the Treasury issued more long-term bonds relative to short-term securities.

It is true the Treasury appears to be undermining QE2 by preventing the average duration of treasury securities from decreasing. The point of shorting the average duration is to cause a portfolio readjustment that will ultimately lead to more nominal spending. Here is how I described this process:

Currently, short-term Treasury debt like T-bills are near-perfect substitutes for bank reserves because both earn close to zero percent and have similar liquidity. In order for the Fed to get investors to spend some of their money holdings it must first cause a meaningful change in their portfolio of assets. Swapping T-bills for bank reserves will not do it because they are practically the same now. In order to get traction, the Fed needs to swap assets that are not perfect substitutes. In this case, the Fed has decided to buy less-liquid, higher-yielding, longer-term Treasury securities. Doing so should lower the average maturity of publicly-held U.S. debt. It should also overweight investor's portfolios with highly-liquid, lower-yielding assets and force investors to rebalance them. In order to rebalance their portofolios, investors would start buying higher-yielding assets like stocks and capital. This would ultimately drive up consumption spending--through the wealth effect--and investment spending. The portfolio rebalancing, then, ultimately cause an increase in nominal spending. Given the excess economic capacity, this rise in nominal spending should in turn raise real economic activity.

Arnold is skeptical this portofolio balancing channel is working because of Treasury's actions. He may be right. Treasury's actions are probably preventing some of the portfolio rebalancing that would otherwise be occurring because of QE2. But Treasury is not completely thwarting QE2. QE2 appears to be raising nominal expectations that in turn are causing the investors to rebalance their portofolios. Here is how this shaping of nominal expectations should work:

If the Fed could convince investors that it is committed to the objective of higher nominal spending and higher inflation... then much of the rebalancing could occur without the Fed actually buying the securities. For if investors believe there will be a Fed-induced rise in nominal spending that will lead to higher real economic growth and thus higher real returns, they will on their own accord start rebalancing their portfolios toward higher yielding assets. Likewise, if investors anticipate higher inflation, then the expected return to holding money assets declines and causes them to rebalance their portfolios toward higher yielding assets. In other words, by properly shaping nominal expectations the Fed could get the market to do most of the heavy lifting itself. I believe this is why QE2 is still having some effect despite the Treasury working against it.

We will know for sure if this portfolio rebalancing is working come March 10. At that time the latest Flow of Funds data will be released and from it we will be able to see if the private sector's portfolio of assets has changed.